A Big Story, Missed

We in the news business often miss big stories because they aren't announced by a corpse, scandal, invasion or controversy. One important story we're missing today is the absence of sharply higher inflation. Look at the numbers. For the past 12 months the consumer price index (CPI) is up only 2.5 percent; since 1997 annual increases have averaged 2.4 percent. So-called core inflation -- stripped of volatile food and energy prices -- has behaved even better. In 2004 core inflation was 2 percent; recently the annual rate has been running at about 1 percent. The significance of these drab statistics may not be immediately obvious, so let's explain.

Time was when an economic recovery in its third or fourth year -- and this one has run 31/2 years -- would generate rising wages and prices that would choke the expansion and lead to a recession. Between 1969 and 1981, rising inflation (peaking at 13 percent in 1979 and 1980) triggered four recessions. The worst, in 1981-82, inflicted monthly unemployment as high as 10.8 percent.

Low inflation today underlies the economy's continued resilience. It especially helps explain low long-term interest rates and, hence, the housing boom. (As inflation falls, so do interest rates on mortgages and bonds, because there's less danger that loan repayments to banks and other lenders will be made in cheaper dollars.) Even many experts are surprised by the economy's new inflation immunities. "A year and a half ago, almost every forecaster thought inflation would be higher," says economist Nariman Behravesh of Global Insight. One reason that higher oil prices haven't yet crippled the economy is that they haven't triggered a widespread jump in wages and other prices. There are many theories to explain the economy's greater inflation resistance: stiffer competition, higher productivity, spreading globalization and "slack" in labor markets. All may be partially true.

Airlines would love to pass higher fuel prices along in the form of higher fares, but competition usually frustrates that. In the first quarter of 2005, airfares dropped 4.3 percent from a year earlier, the Transportation Department reports. Similarly, higher productivity (aka efficiency) and intense import competition have reduced the prices of many manufactured goods. In June new car prices -- after adjustment for quality improvements -- were actually 2.1 percent lower than 10 years earlier, according to the Bureau of Labor Statistics. Shoes were 2.3 percent lower. Washers and dryers were only 1.7 percent higher.

As for labor-market "slack," the theory is simple. If there are more job seekers than jobs, supply and demand keep wage gains down. Now, however, unemployment is only 5 percent -- fairly low historically. Still, companies don't seem to be bidding up wages and salaries to attract scarce workers.

Over the past year labor costs have risen only 3.2 percent. One possible explanation is that there's more "slack" in labor markets than the unemployment rate suggests. Some discouraged workers may have stopped looking for jobs. This lowers the unemployment rate, because people who aren't looking for work aren't counted as jobless. Economist Katharine Bradbury of the Federal Reserve Bank of Boston has estimated that the unemployment rate might be one percentage point higher -- or more -- if labor-force participation rates were higher.

Give all these theories their due. Still, the main reason for inflation's good behavior lies elsewhere: Expectations have changed. In the 1970s and early 1980s, the wage-price spiral became self-fulfilling. Because managers and workers believed there would be inflation, there was. Facing higher costs, companies immediately sought to pass them along in higher prices. Facing higher prices, workers expected to be compensated with higher wages. Companies obliged, fearing that otherwise they would lose good workers and knowing that they could then raise prices. From 1975 to 1981, labor costs rose 9.4 percent annually and the CPI climbed 9.2 percent.

The central legacy of the Alan Greenspan era at the Federal Reserve (his term ends early next year) is the suppression of this self-destructive psychology. The inflationary process of the 1970s stemmed from government policies of cheap credit and easy money that were intended to reduce unemployment. The decisive reversal of policy occurred in the early 1980s, when then-Fed Chairman Paul Volcker squeezed credit and caused a massive recession. By 1983 inflation had dropped to about 4 percent.

Greenspan has sustained that progress by preempting any resurgence of inflation; indeed, the Fed's recent increases in the overnight fed funds rate (from 1 percent in June 2004 to 3.25 percent now) have that purpose.

It's easier to control inflation -- and stabilize the economy -- if people don't believe that high inflation is inevitable and are automatically raising wages and prices. Little wonder that the economy has done better in the past 20 years than it did in the previous 20. Since 1982 there have been only two recessions. But the transformation has occurred so slowly that most Americans simply take it for granted. It's a hugely significant story, even if it's mostly ignored.